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“California Overnight Dividends”

By Travis Johnson, Stock Gumshoe, September 10, 2007

“Is it really possible to safely make $5,500 or more, in cash, in the next 24 hours?”

That’s how they open this teaser for a new investment newsletter from Stansberry and Associates, called Jeff Clark’s Advanced Income. And just as an aside, duh, of course you can safely make $5,500 or more in 24 hours … it all depends on how much you start with. If you’re starting with $10,000, then no way is it going to be “safe” …. if you’re starting with a milllion, probably it would be reasonably easy.

But on to brass tacks, this teaser is for the California Overnight Dividend, another piece of evidence that Stansberry at least has some clever copywriters who come up with interesting new names for investment strategies.

So is it real?

“And the best part is, this is not a one-time thing. You can continue collecting these payments as often as every single month… for as long as you chose.”

This is money that you keep, so we’re clearly not talking about unrealized stock gains here — it has to be at least somewhat comparable to a dividend.

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He gives a examples of these “California Overnight Dividends” that you could have recently collected:

Interoil (IOC): If you owned 1,000 shares, you could have pocketed a “dividend” of $3,500.

Crocs (CROX): If you owned 1,000 shares of this one, you could have gotten $5,500.

And Zumiez (ZUMZ): 1,000 shares would have gotten you a payment of $4,000.

That all sounds pretty good, right? Of course, none of these companies actually pay a dividend, so what on earth are we talking about?

“It’s often possible for you to collect “Overnight Dividends” six, eight, or even 12 times in a single year, using the same stock.”

They also give several examples for collecting these “overnight dividends” on Devon Energy, which you could have gotten many times through the last year or so.

Other clues?

These “dividends” are only available for “about 30%” of the companies in the market.

Throw in a few quotes from several investment gurus, including Richard Lehman, who wrote a recent book on this very topic, and the Gumshoe can lift the veil and tell you that this is a teaser for …

Well, not a particular stock, or fund, or anything like that. Makes the “reveal” a little less sexy, eh?

This is a teaser for selling covered call options as an income strategy.

For those who just said, “huh?”, you need to know a few things:

1, call options are contracts, traded every day on thousands of stocks, that give you the option of buying shares in a particular company at a particular price (the strike price) before a particular date (the expiration date).

2, call options often trade at a premium to the stock price, sometimes a very significant premium, even for near-term options.

Here’s an example, using one of the companies in the teaser:

CROX has options available with a wide variety of strike prices — there’s one for October (which means it expires on the third Friday of October) at $55. With the regular CROX shares at $57 or so right now, you can tell immediately that this option is worth $2 a share. That’s the difference between the strike price and the current share price.

BUT, that particular option is trading for about $6 right now. So what’s that extra $4 for?

That’s what someone’s willing to pay to bet that CROX shares will go up sometime between now and the third Friday in October. Which implies that this person is betting that the shares will go up to at least $61, since that’s what it would take for the option to really be “worth” $6 on the expiration date.

Each option represents 100 shares, with some rare exceptions, so are you getting the flip side of what we’re talking about here?

That’s right — the California Overnight Dividend is what’s earned by people who SELL those call options.

So, in the case of the Interoil example given above, the shares are trading for about $33.50. You buy 1,000 shares of that, so not a small outlay at $33,500.

Then, you can sell up to 10 “covered” call options (“covered” means that you own the stock that you sell the options on, so you can uphold your end of the bargain without doing any risky betting or using lots of margin debt.) The 10 comes from remembering that each option is for 100 shares, so 10 options would represent 1,000 shares.

Now, when you sell those options (this does match the teaser, which came out before the market swooned on Friday), you get to pocket the money you get for selling them. So if you decide to sell a near term option for October, at slightly more than the stock price ($35, in this case), that was indeed going for about $3.50 a few days ago and you could pocket $3,500.

It’s also true that this is immediate, just like any other stock or option transaction, so you can certainly do it in 24 hours if you want to. No reason you have to, of course.

But there’s got to be a catch, right?

Well, of course.

You’ve sold your options at $35 for October in Interoil, so you’re essentially betting that the shares will NOT go above $35 before the expiration date of the option. Or at least, that they won’t go above $38.50 (the $35 strike price plus the $3.50 per share that you got for the option). If that’s how it works, you come out ahead.

If the share price stays the same for a month, you still get your $3,500. If it drops significantly, you’ve still got your $3,500 to ease the pain (though it gets tricky if it drops so badly that you want to sell it before the expiration date — since you’ve already sold someone the right to buy it from you, your broker might not like you to sell shares that you’ve already sold covered calls on).

But here’s the tricky part: If Interoil reports windfall earnings, or discovers a new oil well, or agrees to be bought out by a bigger company for a nice premium, you’re probably out of luck.

Let’s say the shares go to $50 before the expiration. You’ve still got your $3,500 for selling the call option, but the shares that should normally then be worth $50,000 thanks to this huge $50 per share windfall (remember, you’ve still got 1,000 shares), are actually only worth $35,000 to you.

That’s because, yes, you’re following along nicely, you already sold someone the right to buy all of your shares at $35. And now that the rest of the market thinks those shares are worth $50, the person who bought your call option will undoubtedly want to exercise that right, buy the shares from you for $35, and sell them immediately to someone else for $50.

That’s why people buy options — they’re betting that the price will go up.

And the folks who sell them those options — the people receving the “California Overnight Dividends” are hoping that the shares will stay more or less where they are, at least until the expiration date.

Now, it’s true that selling covered calls can be an excellent way to sort of scrape some income off the top of your portfolio without necessarily having to sell any shares (though there’s always that risk) — but it’s not always necessarily easy, and it does get rid of the booming upside that you occasionally see in stocks.

If you believe that the market is going to tread water or go down for a particular period of time, then selling off options on your stock positions is a reasonable way to get some income from positions that otherwise would sit in your portfolio and do you no good.

And, as teased, if you’re both right and lucky you can do it over and over — if the price of Interoil never goes above $35 before your expiration date, then you watch that date go by with glee as you just made $3,500 in free money. And you could then sell options on those same 1,000 shares again, since you still own the original shares — just choose a new expiration date and a new strike price and make your sale.

The two caveats I’d remember if trying to implement this strategy, whether you decide that you want to subscribe to a service that tries to coordinate it for you or you do it on your own, are:

A) You need to have pretty big positions in each stock — if you have just 100 shares, that’s only one option that you can sell, and the commissions for options, which are often higher than for stocks, will eat into your returns significantly. If you have less than 100 shares, you can’t sell even one option so this won’t work for you.

and B) You need to be very disciplined — you have to focus on this as a strategy for making short term income, and pick companies that you think have overly large option premiums but that you predict will not go up particularly quickly. If you’re like me, that situation when your stock doubles after you sold options on it is going to drive you batty, so I’d suggest going into this only after convincing yourself that you won’t be bothered by those lost opportunities and will be happy with just your relatively stable gains from selling the options.

There are two ways to make relatively large amounts of money in a single options sale, as was teased about in the three options given — one is to give up a lot of time by having your expiration date far in the future — even two or three years in some cases, and the other is to sell at close to the current share price. So these three companies, which are all pretty fast growing companies, would have gotten you something close to a one time payment of 10% for selling call options for one month out near the share price.

If you wanted to improve your odds of keeping the shares, you could up the strike price. But then the income goes down pretty dramatically. Where you might have gotten $3,500 for the $35 strike price option in Interoil for October, you would have gotten only $1,500 or so if you bumped the strike price up to $40. Then, if you really wanted that $3,500 you could have given the options buyer a little more time — you could have gotten $3,500 for Interoil options at $40 as long as you pushed the expiration date out to December to give the buyer more time for the price to potentially go up.

In the cases teased here, from the dollar amounts given I’d guess that the options seller was giving up very little time (ie, selling options with an expiration date that’s within a month or two) BUT selling at “close to the money,” which means a strike price that’s pretty close to the current share price. That’s what you would have to do if you wanted to sell options 8 or 10 times a year, since you’d have to be able to roll them over pretty frequently.

Is this a good strategy for you? Well, if you really need income and think your stocks will be flat or down but you still want to hold on to them, it can work. You might think of it as essentially giving away (well, selling) any potential windfall gains in exchange for a better chance of steady gains.

I know it’s not terribly crazy, nor is it out of left field, lots of people and institutional investors sell covered calls as a hedge or as an income strategy, and there are even mutual funds and closed-end funds that use this strategy to goose their returns … whether it’s a good call for you is, of course, something I can’t tell you. If any of you sell covered calls for income, or just want to opine, feel free to share your experiences by commenting below.

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14 years ago

Glad to hear the discussion. Selling covered calls is very attractive and I’ve analyzed it enough to see one major danger and one minor danger in an apparently lucrative endeavour. I’m looking for the proper hedge for the major danger. The major danger as I perceive it is when the price trends down. Yes, you keep your option premium but if you keep sellng calls on your decreasing investment you may be exercised when the price ticks up and that is when you take losses on your capital. I need to see if a put strategy at the time of the original call writing is economical. The minor danger is when the stock takes off and you miss out on the gain (except for your premium received). If you buy back into the stock you can’t buy as many shares as you originally had so you’re at the same risk level from price depreciations that you had on the prior buy/write cycle.

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14 years ago

The one thing not mentioned in this discussion: how are the proceeds treated tax-wise?

13 years ago

I have had excellent service from optionsXpress. ThinkOrSwim has a fantastic new application that is free to download. In a down market I sell puts to buy the stock and then write a covered call when the stock is put to me. The ideal for me is for both the put and call to be exercised to increase profit. That very seldom happens thus the returns are small. It does hurt when the stock shoots up and I only get a 10% profit. In an up market, I buy the stock and then write a covered call. This method of trading only takes about an hour per week – good when working full time.

optionsXpress has a “Screener” routine I use to select covered calls for a good monthly return. I avoid ALL medical/banks/construction stocks. Mostly energy and shipping. I know shipping is being hurt by the banks right now, but they still pay good dividends.

For the Screener, I set the following parameters:
Last Price from 5 to 15 (cheep stocks to buy)
Avg Volume from 250K (can’t trade if no one buys)
P/E from 0 to 20 (This limits the scan)
Last Price from 0.50 to 4.50
Volume greater than zero
Open Interest greater than 100
Return from 5% to 39%

This will often return around 300 options and I can select the one I like. For example, just now CLR (oil stock at $13.54) with a P/E of 6.57 and a net income of $381 million has an otm put of $2.60 and an otm call of $2.30. If you really, really like the company and think the price will stay above $12.50, this is a good return for either a put or covered call. If you think the stock price might drop below $12.50 – look somewhere else.

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